1. Managerial Economics & Business Strategy
Chapter 11
Pricing Strategies for Firms with Market Power
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

2. Overview I. Basic Pricing Strategies II. Extracting Consumer Surplus
Monopoly & Monopolistic Competition
Cournot Oligopoly
II. Extracting Consumer Surplus
Price Discrimination  Two-Part Pricing
Block Pricing  Commodity Bundling
III. Pricing for Special Cost and Demand Structures
Peak-Load Pricing  Price Matching
Cross Subsidies  Brand Loyalty
Transfer Pricing  Randomized Pricing
IV. Pricing in Markets with Intense Price Competition
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

3. Standard Pricing and Profits
Price
Profits from standard pricing
= $8 10 8 6 4 2 MC
P = Q
Quantity
MR = Q
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

4. An Algebraic Example P = 10 - 2Q C(Q) = 2Q
If the firm must charge a single price to all consumers, the profit-maximizing price is obtained by setting MR = MC
10 - 4Q = 2, so Q* = 2
P* = (2) = 6
Profits = (6)(2) - 2(2) = $8
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

5. A Simple Markup Rule
Suppose the elasticity of demand for the firm’s product is EF
MR = P[1 + EF]/ EF
Setting MR = MC and simplifying yields this simple pricing formula:
P = [EF/(1+ EF)]  MC
The optimal price is a simple markup over relevant costs!
More elastic the demand, lower markup.
Less elastic the demand, higher markup.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

6. An Example Elasticity of demand for Kodak film is -2
P = [EF/(1+ EF)]  MC
P = [-2/(1 - 2)]  MC
P = 2  MC
Price is twice marginal cost
Fifty percent of Kodak’s price is margin above manufacturing costs.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

7. Markup Rule for Cournot Oligopoly
Homogeneous product Cournot oligopoly
N = total number of firms in the industry
Market elasticity of demand EM
Elasticity of individual firm’s demand is given by EF = N EM
P = [EF/(1+ EF)]  MC, so
P = [NEM/(1+ NEM)]  MC
The greater the number of firms, the lower the profit-maximizing markup factor
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

8. An Example Homogeneous product Cournot industry, 3 firms MC = $10
Elasticity of market demand = - 1/2
Profit-maximizing price?
EF = N EM = 3  (-1/2) = -1.5
P = [EF/(1+ EF)]  MC
P = [-1.5/(1- 1.5]  $10
P = 3  $10 = $30
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

9. First-Degree or Perfect Price Discrimination
Practice of charging each consumer the maximum amount he or she will pay for each incremental unit
Permits a firm to extract all surplus from consumers
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

10. Perfect Price Discrimination
Profits:
.5(4-0)(10 - 2)
= $16 10 8 6 4
Total Cost 2 MC D
Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

11. Caveats:
In practice, transactions costs and information constraints make this is difficult to implement perfectly (but car dealers and some professionals come close).
Price discrimination won’t work if consumers can resell the good.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

12. Second Degree Price Discrimination
The practice of posting a discrete schedule of declining prices for different quantities.
Example: Electric utilities MC
$10 $8 $5 D 2 4
Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

13. Third Degree Price Discrimination
The practice of charging different groups of consumers different prices for the same product
Examples include student discounts, senior citizen’s discounts, regional & international pricing
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

14. Implementing Third Degree Price Discrimination
Suppose the total demand for a product is comprised of two groups with different elasticities, E1 < E2
Notice that group 1 is more price sensitive than group 2
Profit-maximizing prices?
P1 = [E1/(1+ E1)]  MC
P2 = [E2/(1+ E2)]  MC
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

15. An Example
Suppose the elasticity of demand for Kodak film in the US is EU = -1.5, and the elasticity of demand in Japan is EJ = -2.5
Marginal cost of manufacturing film is $3
PU = [EU/(1+ EU)]  MC = [-1.5/( )]  $3 = $9
PJ = [EJ/(1+ EJ)]  MC = [-2.5/( )]  $3 = $5
Kodak’s optimal third-degree pricing strategy is to charge a higher price in the US, where demand is less elastic
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

16. Two-Part Pricing
When it isn’t feasible to charge different prices for different units sold, but demand information is known, two-part pricing may permit you to extract all surplus from consumers.
Two-part pricing consists of a fixed fee and a per unit charge.
Example: Athletic club memberships
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

17. How Two-Part Pricing Works
Price
1. Set price at marginal cost.
2. Compute consumer surplus.
3. Charge a fixed-fee equal to consumer surplus. 10 8 6
Fixed Fee = Profits = $16
Per Unit
Charge 4 2 MC D
Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

18. Block Pricing
The practice of packaging multiple units of a product together and selling them as one package.
Examples
Paper
Six-packs of drinks
Different sized of cans of green beans
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

19. An Algebraic Example Typical consumer’s demand is P = 10 - 2Q
C(Q) = 2Q
Optimal number of units in a package?
Optimal package price?
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

20. Optimal Quantity To Package: 4 Units
Price 10 8 6 4 2
MC = AC D
Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

21. Optimal Price for the Package: $24
Consumer’s valuation of 4
units = .5(8)(4) + (2)(4) = $24 10 8 6 4 2
MC = AC D
Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

22. Costs and Profits with Block Pricing
Price 10 8
Profits = $16 6 4
Costs = $8 2
MC = AC D
Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

23. Commodity Bundling
The practice of bundling two or more products together and charging one price for the bundle
Examples
Vacation packages
Computers and software
Film and developing
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

24. An Example that Illustrates Kodak’s Moment
Total market size is 4 million consumers
Four types of consumers
25% will use only Kodak film
25% will use only Kodak developing
25% will use only Kodak film and use only Kodak developing
25% have no preference
Zero costs (for simplicity)
Maximum price each type of consumer will pay is as follows:
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

25. Reservation Prices for Kodak Film and Developing by Type of Consumer
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

26. Optimal Film Price?
Optimal Price is $8, to earn profits of $8 x 2 million = $16 Million
At a price of $4, only first three types will buy (profits of $12 Million)
At a price of $3, all will types will buy (profits of $12 Million)
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

27. Optimal Price for Developing?
At a price of $6, only “D” type buys (profits of $6 Million)
At a price of $4, only “D” and “FD” types buy (profits of $8 Million)
At a price of $2, all types buy (profits of $8 Million)
Optimal Price is $3, to earn profits of $3 x 3 million = $9 Million
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

28. Total Profits by Pricing Each Item Separately?
$16 Million Film Profits + $9 Million Development Profits =$25 Million
Surprisingly, the firm can earn even greater profits by bundling!
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

29. Pricing a “Bundle” of Film and Developing
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

30. Consumer Valuations of a Bundle
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

31. What’s the Optimal Price for a Bundle?
Optimal Bundle Price = $10 (for profits of $30 million)
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

32. Peak-Load Pricing
Price
When demand during peak times is higher than the capacity of the firm, the firm should engage in peak-load pricing.
Charge a higher price (PH) during peak times (DH)
Charge a lower price (PL) during off-peak times (DL) MC PH DH PL
MRH DL
MRL QL QH
Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

33. Cross-Subsidies
Prices charged for one product are subsidized by the sale of another product
May be profitable when there are significant demand complementarities effects
Examples
Browser and server software
Drinks and meals at restaurants
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

34. Transfer Pricing
The internal price at which an upstream division sells inputs to a downstream division in order to maximize the overall profits of the firm.
In order to maximize profits, the upstream division produces such that its marginal cost, MCu, equals the net marginal revenue to the downstream division (NMRd):
NMRd = MRd - MCd = MCu
This permits the firm to avoid double-marginalization.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

35. Double Marginalization
A wholesaler (or upstream firm) marks up its price when selling to a retailer (or downstream firm)
The retailer (or downstream firm), in turn, further marks up price.
Double marginalization results in lower profits for the wholesaler. Why?
An Example:
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

36. Wholesaler’s Problem Demand for the final product P = 10 - 2Q
C(Q) = 2Q
Suppose the wholesaler sets MR = MC to maximize profits
10 - 4Q = 2, so Q* = 2
P* = (2) = $6, so wholesaler charges the retailer $6 per unit
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

37. Retailer’s Problem Demand for the final product P = 10 - 2Q
Retailer’s marginal cost is the $6 charged by the wholesaler
Retailer sets MR = MC to maximize profits
10 - 4Q = 6, so Q* = 1
P* = (1) = $8, so retailer charges $8 per unit
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

38. Analysis
This pricing strategy by the wholesaler results in less than optimal profits!
Wholesaler needs the price to be $6 and the quantity sold to be 2 units in order to maximize profits. Unfortunately,
The retailer sets price at $8, which is too high; only 1 unit is sold at that price.
The wholesaler’s profits are $6  1 - 2(1) = $4 instead of the monopoly profits of $6  2 - 2(2) = $8
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

39. Wholesaler’s “Monopoly Profits”
Price $8 10 8 6 4 2
MC = AC
P = Q
Quantity
MR = Q
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

40. Wholesaler’s Profits when Retailer Marks price up to $8$4
Retail
Price 10 8 6 4 2
MC = AC
P = Q
Quantity
MR = Q
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

41. Solutions for the Wholesaler?
Force retailers to charge $6. How?
“Suggested retail prices?”
Vertical price restraints?
Vertical quantity restraints?
Integrate into retailing?
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

42. Pricing in Markets with Intense Price Competition
Price Matching
Advertising a price and a promise to match any lower price offered by a competitor.
No firm has an incentive to lower their prices.
Each firm charges the monopoly price and shares the market.
Randomized Pricing
A strategy of constantly changing prices.
Decreases consumers’ incentive to shop around as they cannot learn from experience which firm charges the lowest price.
Reduces the ability of rival firms to undercut a firm’s prices.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

43. Recap of Pricing Strategies
First degree price discrimination, block pricing, and two part pricing permit a firm to extract all consumer surplus.
Commodity bundling, second-degree and third degree price discrimination permit a firm to extract some (but not all) consumer surplus.
Simple markup rules are the easiest to implement, but leave consumers with the most surplus and may result in double-marginalization.
Different strategies require different information.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999